The Impact of the Recovery Act on Economic Growth
by Simon Johnson, Peterson Institute for International Economics
Testimony before the Joint Economic Committee hearing on "The Impact of the Recovery Act on Economic Growth"
October 29, 2009
The remainder of this testimony reviews current US macroeconomic issues in broad terms, assesses the lessons of Japan's experience in the 1990s, and makes proposals for further essential reform (both fiscal and financial).
Current US Issues
To be a strong global leader in the future, America needs to generate an environment where entrepreneurship, technological innovation, and immigration ensure that the nonfinancial private sector can continue to propel the US economy.
It is premature to argue that the US economy has stumbled into a "new normal" paradigm that involves slower growth. The factors that drove our growth over the last 150 years, particularly entrepreneurial startups and the commercialization of invention, remain despite the crisis. Indeed, these drivers of growth may become even stronger in the future if we can reduce the wasteful financial sector activities3 that grew since the 1980s (and really flourished over the past decade) and allocate resources to more productive activities in the future.
America needs a new framework to harness that growth. That framework needs to address the following problems with our current economic structure.
Problem 1: With the recent financial sector bailouts, we have sent a simple message to Americans: The safest place to put your savings is in a bank, even if that bank is so poorly managed, and has such large balance sheet risks, that just six months ago it almost went bankrupt.
Despite being near to bankruptcy six months ago, Bank of America credit default swaps now cost only 103 basis points per year to protect against default, and the equivalent rate for Goldman Sachs is a mere 89 basis points. Goldman Sachs is able to borrow for five years at just 170 basis points above treasuries. This is not a sign of health; rather it indicates the sizable misallocation of capital promoted by current policies. America's leading nonfinancial innovators would never be able to build the leverage (debt-asset ratio) on their balance sheet that Goldman Sachs has, and then borrow at less than 2 percent above US treasuries. The implicit government guarantee is seriously distorting incentives.
Problem 2: We have not changed the incentive structures4 for managers and traders within our largest banks. Arguably these incentives are more distorted than they were before the crisis. So the problems of excessive risk taking and a new financial collapse will eventually return. Financial system incentives are a first-order macroeconomic issue, as we have learned over the past 12 months.
Today bank management is strongly incentivized to take large risks in order to raise profits, increase bank capital, and pay large bonuses to "compete for talent." Since they have access to a pool of funds effectively guaranteed by the state through being "too big to fail," there is the potential to make large profits by employing funds in risky trades with high upside. Such activities do not need to be socially valuable, i.e., it could be that the expected return on the investments is negative, but as the downside has limited liability, the banks can go ahead.
Problem 3: We have not changed the financial regulatory framework in a substantive way so as to limit excessive risk taking. The proposals currently proceeding through Congress are unlikely to make a significant difference.5
Problem 4: The policy response to this crisis, with very low interest rates and a large fiscal stimulus, is merely a larger version of the response to previous similar crises. While this was essential to stop a near financial collapse, it reinforces the message that the system is here to stay.
Problem 5: The public costs of this bailout are much larger than we are accounting for, and people who did not cause this crisis are ultimately paying for it. Taxpayers and savers are the big losers each time we have these crises. We are failing to defend the public purse.
Our financial leaders have emphasized that our banks are well capitalized, and no new public funds are likely to be needed to support them. This is misleading. The current monetary stance is designed to ensure that deposit rates are low, and the spread between deposit rates and loan rates is high. This is a massive transfer of public funds to the private sector, and no one accounts for that properly.
It is striking that the chairman of the Federal Reserve himself, in a recent speech, stated that no more public funds were needed to bail out banks. His institution continues to provide massive transfers to the banking system through loose credit and low interest rate policy. That credit could instead go to others; the Federal Reserve has chosen to transfer those funds to banks. This policy was used in the past to recapitalize banks (e.g., after 1982), but we have now a very different financial sector—with much more capacity to take high risks and a greater tendency to divert profits into large cash bonuses.
Today, depositors in banks earn little more than the Federal Funds rate and are effectively financing our financial system. We are giving them very low returns on their savings because the losses in the financial system were so large in the past. This is essentially public money—it is the pensioners, elderly people with savings, and other people who have no involvement in the financial system, who are being required to suffer low returns to support the banks.
We Are Not Japan
After the bursting of its real estate bubble at the end of the 1980s, Japan faced a serious problem in its financial sector. This fact has inspired many people to look for parallels with the current US situation, and—in some cases—to draw the implication that we should pursue further large-scale fiscal stimulus today.
There is a cautionary tale to be learned from the Japanese experience—on the need to promote, rather than to prevent, appropriate macroeconomic adjustment. But this does not encourage a further expansion in the budget deficit at this time.
The property bubble and general credit bubble in Japan were actually much larger than what we recently experienced in the United States. The implied price of the land in the Emperor's Palace, in central Tokyo, was worth more than all of California (or Canada) at its peak. Land prices collapsed and never recovered. US house and land prices never got so far out of line with the earning capacity of homeowners.
The Japanese stock market rose to price-earnings ratio of around 80 (depending on the exact measure), also as a direct result of the credit bubble. The United States did not experience anything similar in the last few years.
Japan was—and largely remains—a bank-based finance system. And their nonfinancial corporate sector was generally much more indebted (often using borrowed money to buy land, but also overexpanding their manufacturing capacity) than was the case in the United States. Total Japanese corporate debt was 200 percent of GDP in 1992—more than double its value in 1984. The implication was a long period of disinvestment and saving by the corporate sector—in fact, this change from the 1980s to 1990s explains most of Japan's increased current account surplus after the crisis. Since Japanese corporates had accumulated too much capital, they exhibited low returns in the post-crisis period. The United States has strong bond and equity markets, and our corporate sector is not heavily indebted—so the cash flow of the nonfinancial sector should bounce back strongly.
In contrast to Japan, the US consumer has much more debt and saves less—in fact, on average over the past decade, our household sector has saved roughly nothing (partly due to the effects of rising wealth from higher house prices). This sector will be weak in the United States. In contrast, in Japan during the 1990s there was no significant increase in household saving (and thus no contribution from this sector to their current account surplus.)
The obvious solution for any country in the situation faced by the United States is to let the economy adjust, which implies and requires that the real exchange rate depreciates—so our exports go up, our imports (and consumption) go down. This is a level adjustment downward in our GDP and standard of living, but then growth will resume on this new basis.
In contrast, Japan did not grow largely due to their over-investment cycle (in real estate, but also plant and equipment). This created a much more difficult adjustment process, which worked for manufacturing primarily through depreciation of installed capacity and a gradual movement of production off-shore (e.g., to China and other Asian countries).
In addition, another major cause of Japan's poor performance was its demographics and the relatively lackluster growth of its trading partners in Asia due to the Asian crisis. With its working population peaking in 1995, Japan lost a major driver of growth. The country still has strong enterprises and decent productivity growth in the manufacturing sector, which allows them to grow. But the pace is naturally slower than when they were "catching up" through the 1980s. During the last ten years Japan's has grown around the same pace as some of the continental European nations with better but also poor demographics, such as Italy and Germany (the comparison is from Q1 1998 to Q1 20086).
The Japanese policy reaction was to run budget deficits and maintain very loose monetary policy for over a decade, in an attempt to stimulate the economy and obviate the need for painful adjustment (including job losses, recognizing losses at major banks, and properly recapitalizing those banks). Today Japanese gross debt to GDP is at 217 percent and it is still rising7 (net debt, even on the most favorable definition, is over 110 percent of GDP). The working population of Japan is now declining quickly, so those people that are required to pay back the debt face ever-rising burdens. There is a real risk that Japan could end up in a major default, or need a large inflation, to erode the burden of this debt since their current path is clearly unsustainable.
Japan's policy approach from the 1990s—repeated fiscal stimulus and very easy money—is not an appealing model for the United States today. All dynamic economies have a natural adjustment process—this involves allowing failing industries to decline, and letting new businesses develop where there are new opportunities.
In fact, while Japan hesitated for over a decade to let this process work (particularly protecting the insiders at their major banks), it has finally moved in this direction. Unit labor costs in Japan have declined sharply over the last ten years, helping making the country a more competitive exporter. The forced recapitalization of some major banks at the end of the 1990s was also a move in the right direction.
The process of deflation—spoken of with terror by some leading central banks around the world today—actually makes industry more competitive, and while there are negative aspects to it (particularly if the household sector is heavily indebted, as in the United States), the modest price declines seen in Japan are not a disaster. In fact, real GDP per worker in Japan—annualized over the past 20 years—has increased by 1.3 percent per annum; while the comparable number in the United States is 1.6 percent. Over the past ten years, real GDP per worker (annualized) increased by 1.3 percent in both Japan and the United States—and now it turns out that much of the GDP gains in the US financial sector may have been illusory.
The Japan-US comparison is not generally compelling, particularly as Japan ran a current account surplus even during its destabilizing capital inflows of the 1980s. The current US experience more closely matches the experience in some emerging markets, which have in the past run current account deficits, financed by capital inflows—with the illusion that this was sustainable indefinitely.
The long and hard experience of the International Monetary Fund (IMF) with such countries that have "lived beyond their means"—or overexpanded in any fashion—is that it is a mistake to try to prevent this process of competitive adjustment, i.e., bringing spending back into line with income, which implies a smaller current account deficit or even a surplus. The adjustment can be cushioned by fiscal policy—and here the IMF has changed its line over the past few years, now offering sensible support for this approach. But attempting to postpone adjustment with repeated fiscal stimulus is almost always a mistake.
Japan did not want to force its corporate sector to adjust (i.e., in the sense of going bankrupt and renegotiating its debts), so it offered repeated stimulus. As a result, it has become stuck with a "permanent" fiscal deficit program that is now threatening their survival as a global economic power, and will—regardless of the exact outcome—burden future generations for decades.
Some analysts further claim that Japan's early withdrawal of stimulus is a major factor explaining why they have not returned to robust growth rates. It is true that Japan introduced a new VAT tax in April 1997 not long before the Asian Financial Crisis began, and the Bank of Japan raised interest rates by 25 basis points in August 2000. Subsequent to these changes the economy slowed down.
However, each of these measures was relatively small. The Bank of Japan reversed course on interest rates quickly, and a negative turn in the economy was surely already in the cards—this occurred at the same time as the global economy slowed down, and a great stretch to argue that a 25-basis-point move could explain the poor performance of Japan's economy for years or decades subsequent.
As long as there are not major adverse shocks from the rest of the world, the United States will experience higher savings, a fall in consumption, a recovery in investment, and an improvement in the its net exports (so the current account deficit will become smaller, or stay at its current level even as the economy recovers). Growth will resume, driven by demographics, technical progress, and entrepreneurship. The high level of unemployment also implies that rapid growth will be fueled by willing workers, subject to the right skills being available.
Proposals for Change
The main threats to the recovery scenario come from the financial system, which has developed serious and macro-level pathologies8 over the past two decades.
We have weak bank regulation and supervision. Politically we can't let banks fail: they bend or lobby to change the rules in order to grow big, and then we bail them out.
New theories of deflation and zero interest rate floors attempt to explain why we need unprecedented large bailouts—with the experience of Japan and the Great Depression of the 1930s offered as partial justification. More likely, we are on an unsustainable fiscal path with the potential for new financial bubbles.
The following changes should be priorities:
Simon Johnson is a senior fellow at the Peterson Institute for International Economics and a professor at MIT.
1. Fiscal Policy as a Countercyclical Tool, http://www.imf.org/external/pubs/ft/weo/2008/02/pdf/c5.pdf
2. Simon Johnson and James Kwak, "The home-buyer tax credit: Throwing good money after bad," Washington Post, October 27, 2009, http://www.washingtonpost.com/wp-dyn/content/article/2009/10/27/AR2009102703791.html.
3. Simon Johnson and James Kwak, "Finance: Before the Next Meltdown," Democracy: A Journal of Ideas, Summer 2009, http://www.democracyjournal.org/article.php?ID=6701.
4. Simon Johnson, " What We've Learned: The Beast Still Lives," New York Times, September 10, 2009, http://economix.blogs.nytimes.com/2009/09/10/what-weve-learned-the-beast-still-lives/.
5. Simon Johnson, "Where Are We Again?," Baseline Scenario, September 14, 2009, http://baselinescenario.com/2009/09/14/where-are-we-again-pre-g20-pittsburgh-summit/.
6. Graeme Chamberlin and Linda Yueh, "Recession and recovery in the OECD," Economic & Labour Market Review, October 2009, http://www.statistics.gov.uk/elmr/10_09/downloads/ELMR_Oct09_Yueh.pdf.
7. IMF, "Japan: Selected Issues," IMF Country Report No. 09/211, July 2009, http://www.imf.org/external/pubs/ft/scr/2009/cr09211.pdf
8. Simon Johnson, "The Quiet Coup," The Atlantic, May 2009, http://www.theatlantic.com/doc/200905/imf-advice.